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Trading and Capital-Markets Activities Manual

Trading Activities: Ethics
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

Senior management of financial institutions should establish ethical standards and codes of conduct governing the activities of their employees to protect the institution's integrity and standing in the market. The orderly operation of financial markets depends greatly on an overall level of trust among all market participants. Traders and marketing and support staff must conduct themselves at all times with unquestionable integrity to protect the institution's reputation with customers and market participants. 

CODES OF CONDUCT AND ETHICAL STANDARDS 

To ensure that employees understand all ethical and legal implications of trading activities, institutions should have comprehensive rules of conduct and ethical standards for capital-markets and trading activities-especially in areas where the complexity, speed, competitive environment, and volume of activity could create the potential for abuse and misunderstandings. At a minimum, policies and standards should address potential conflicts of interest, confidentiality and the use of insider information, and customer sales practices. Ethical standards and codes of conduct in these areas should conform with applicable laws, industry conventions, and other bank policies. They should also provide proper oversight mechanisms for monitoring staff compliance and dealing with violations and customer complaints. Internal controls, including the role of internal and external audits, should be appropriate to ensure adherence to corporate ethical standards of conduct. Policies and procedures should provide ongoing training for staff, as well as periodic review, revision, and approval of ethical standards and codes of conduct to ensure that they incorporate new products, business initiatives, and market developments. 

Conflicts of Interest 

Institutions should ensure that capital-markets personnel do not allow self-interest to influence or give the appearance of influencing any activity conducted on behalf of the institution. Safeguards should include specific restrictions on trading for the employee's personal account and on the acceptance of gratuities and entertainment. When developing compensation programs, institutions should recognize and guard against any potential conflicts that may arise between compensation structures and the institution's code of ethics and standards of conduct. 

Fee-based activities, securitization, underwriting, and secondary-market trading activities in a number of traditional bank assets may create the potential for conflicts of interests if there is no clear segregation of duties and responsibilities. Conflicts of interest may arise when access to inside information gives an institution an unfair advantage over other market participants. Accordingly, policies should ensure that employees conduct themselves consistent with legal and regulatory restrictions on the use of inside information. 

Confidentiality and Insider Information 

The maintenance of confidentiality and customer anonymity is critical for the operation of an efficient trading environment. No client information should be divulged outside the institution without the client's authorization unless required by law or by regulatory authorities acting in their official capacities. Managers are responsible for ensuring that their staffs are aware of what constitutes confidential information, and that they know how to deal appropriately with situations that require customer anonymity. 

Many institutions have established appropriate policies (so-called ''Chinese walls'') that separate those areas of the institution that routinely have access to confidential or insider information from those areas that are legally restricted from having access to the information. To prevent the misuse of confidential information, employees in sensitive areas should be physically segregated from employees in public areas. 

Sales Practices 

It is a sound business practice for managers to establish policies and procedures governing standards for dealing with counterparties. These guidelines and policies preserve the institution's reputation in the marketplace by avoiding situations that create unjustified expectations on the part of a counterparty or client. When determining the responsibilities of sales and marketing staff, management should take into account the sophistication of the counterparty, the nature of the relationship, and the type of transaction being contemplated or executed. In addition, certain regulated entities and markets may have specific legal or regulatory requirements governing sales and marketing practices, which marketers and sales personnel must be aware of. 

Financial institutions should take steps to ascertain the character and financial sophistication of their counterparties. An appropriate level of due diligence should be performed on all counterparties with which the institution deals. Financial institutions should also determine that their counterparties have the legal authority to enter into, and will be legally bound by the terms of, the transaction.

When an advisory relationship does not exist between a financial institution and its counterparty, the transaction is assumed to be conducted at ''arms-length'' and the counterparty is generally considered to be wholly responsible for the transactions it chooses to enter. At times, clients may not wish to make independent investment or hedging decisions and instead may wish to rely on a financial institution's recommendations and investment advice. Similarly, clients may give a financial institution the discretionary authority to trade on their behalf. Financial institutions providing investment advice to clients, or using discretionary authority to trade on a client's behalf, should formalize and set forth the boundaries of these relationships with their clients. Formal advisory relationships may entail significantly different legal and business obligations between an institution and its customers than less formal agency relationships. The authority, rights, and responsibilities of both parties should be documented in a written agreement. 

Marketing personnel should receive proper guidance and training on how to delineate and maintain appropriate client relationships. This includes guidance to sales and trading personnel regarding the avoidance of the implication of an advisory relationship when none is intended. 

While procedures may vary depending on the type and sophistication of a counterparty, for its own protection, a financial institution should take steps to ensure that its counterparties understand the nature and risks inherent in agreed-upon transactions. When a counterparty is unsophisticated, either generally or with respect to a particular type of transaction, the financial institution should take additional steps to adequately disclose the attendant risks of specific types of transactions. Furthermore, a financial institution that recommends specific transactions to an unsophisticated counterparty should ensure that it has adequate information on which to base its recommendation-and that the recommendation is consistent with the needs of the counterparty as known to the financial institution. The institution also should ensure that its recommendations are consistent with any restrictions imposed by a counterparty's management or board of directors on the types or amounts of transactions it may enter into. 

Institutions should establish policies governing the content of sales materials provided to their customers. Typically, these policies call for sales materials that accurately describe the terms of the proposed transaction and provide a fair representation of the risks involved. Policies may also identify the types of analysis to be provided to the customer and often specify that analyses include stress tests of the proposed instrument or transaction over a sufficiently broad range of possible outcomes to adequately assess the risk. Some institutions use standardized disclosure statements and analyses to inform customers of the risks involved and suggest that the customer independently obtain advice about the tax, accounting, legal, and other aspects of a proposed transaction. 

Institutions should also ensure that procedures and mechanisms to document analyses of transactions and disclosures to clients are adequate and that internal controls ensure ongoing adherence to disclosure and customer-appropriateness policies and procedures. Management should clearly communicate to capital-markets and all other relevant personnel any specific standards that the institution has established for sales materials. 

Many customers request periodic valuations of their positions. Institutions that provide periodic valuations of customers' holdings should have internal policies and procedures governing the manner in which such quotations are derived and transmitted to the customer, including the nature and form of disclosure and any disclaimers. Price quotes can be either indicative, meant to give a general level of market prices for a transaction, or firm, which represent prices at which the institution is willing to execute a transaction. When providing a quote to a counterparty, institutions should be careful that the counterparty does not confuse indicative quotes for firm prices. Firms receiving dealer quotes should be aware that these values may not be the same as those used by the dealer for its internal purposes and may not represent other ''market'' or model-based valuations. 

When securities trading activities are conducted in a registered broker-dealer that is a member of the National Association of Securities Dealers (NASD), the broker-dealer will have obligations to its customers under the NASD's ''business conduct rule'' and ''suitability rule.'' The banking agencies have adopted identical rules governing the sales of government securities in financial institutions. The business-conduct rule requires an NASD member to ''observe high standards of commercial honor, and just and equitable principles of trade'' in the conduct of its business. The suitability rule requires that, in recommending a transaction to a customer, an NASD member must have ''reasonable grounds for believing that the recommendation is suitable for the customer upon the basis of facts, if any, disclosed by the customers as to the customer's other securities holdings and as to the customer's financial situation and needs.'' 

The suitability rule further provides that, for customers who are not institutional customers, an NASD member must make reasonable efforts to obtain information concerning the customer's financial and tax status and investment objectives before executing a transaction recommended to the customer. For institutional customers, an NASD interpretation of its suitability rule requires that a member determine (1) the institutional customer's capability for evaluating investment risk generally and the risk of the particular instruments offered and (2) whether the customer is exercising independent judgment in making investment decisions. The NASD interpretation cites factors relevant to determining these two requirements. 

MANAGEMENT OVERSIGHT 

Management should monitor any pattern of complaints concerning trading, capital-markets, and sales personnel that originate from outside the institution, such as from customers, other trading institutions, or intermediaries. Patterns of broker usage should be monitored to alert management to unusual concentrations. Broker entertainment of traders should be fully documented, reviewed, and approved by management. In addition, excessive entertainment of brokers by traders should be prohibited. 

Management should also be well acquainted with the institution's trading activities and corresponding reports so that, upon regular review, they can determine unusual patterns or concentrations of trading activity or transactions with a customer that are not consistent with the customer's usual activities. Management should clearly and regularly communicate all prohibited practices to capital-markets and all other relevant personnel. 

COMPLIANCE MEASURES 

Personnel affirmations and disclosures are valuable tools for ensuring compliance with an institution's code of conduct and ethical standards. Procedures for obtaining appropriate affirmations and disclosures where and when required, as well as the development of forms on which these statements are made, are particularly important. At a minimum, employees should be asked to acknowledge annually that they have read and understood the institution's ethics and code of conduct standards. Some companies also require that this annual affirmation contain a covenant that employees will report any noted violations. Several major financial institutions have adopted additional disclosure procedures to enforce the personal financial responsibilities set out in their codes. They require officers to file with the compliance manager an annual statement dealing with family financial matters or, in some cases, a statement of indebtedness. Finally, many institutions require traders to conduct their personal trading through a designated account at the institution. Adequate internal controls including review by internal audit and, when appropriate, external audit are critical for ensuring compliance with an institution's ethical standards. 

Ethics 

Examination Objectives 

1. To determine if the institution has adequate codes of conduct and ethical standards specific to its capital-markets and trading activities, that their scope is comprehensive, and that they are periodically updated. 

2. To review and ensure the adequacy of the institution's policies, procedures, and internal-control mechanisms used to avoid potential conflicts of interest, prevent breeches in customer confidentiality, and ensure ethical sales practices across the institution's trading activities. To determine if the institution has established appropriate and effective firewall policies where needed. 

3. To determine that management has adequate policing mechanisms and internal controls to monitor compliance with the code of ethics and that procedures for reporting and dealing with violations are adequate. To determine if the supervision of staff is adequate for the level of business conducted. 

4. To recommend corrective actions when policies, procedures, practices, or internal controls are found to be deficient or when violations of laws, rulings, or regulations have been noted. 

Ethics 

Examination Procedures 

These procedures represent a list of processes and activities that may be reviewed during a full-scope examination. The examiner-in-charge will establish the general scope of the examination and work with the examination staff to tailor specific areas for review as circumstances warrant. As part of this process, the examiner reviewing a function or product will analyze and evaluate internal-audit comments and previous examination work-papers to assist in designing the scope of the examination. In addition, after a general review of a particular area to be examined, the examiner should use these procedures, to the extent they are applicable, for further guidance. Ultimately, it is the seasoned judgment of the examiner and the examiner-in-charge as to which procedures are warranted in examining any particular activity. 

1. Obtain copies of the institution's written code of conduct and ethics and any related policies and guidance. Determine if there are codes specific to all relevant trading and marketing activities. 

2. Obtain any procedures used to guide staff in developing new accounts or preparing sales presentations and documents. 

3. Evaluate the various codes and policies as to their adequacy and scope. Are prohibited practices clearly identified? These may include but are not limited to the following: 

a. altering clients' orders without their permission 
b. using the names of others when submitting bids 
c. compensating clients for losses on trades 
d. submitting false price information to public information services 
e. churning managed client accounts 
f. altering official books and records without legitimate business purposes 
g. trading in instruments prohibited by regulatory authorities 

4. Are standards for the content of sales presentations and the offering transaction documents clearly identified? Do these standards address an appropriate range of transactions, customers, and customer relationships? 

5. Review the institutions's firewall policies segregating its trading and advisory activities from those areas which have access to material non-public or ''insider information.'' Are the areas physically separated? Are employees aware of the requirements of the law restricting the use of such information, specifically section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10(b)5? 

6. Identify the officer within the institution who is designated as compliance manager. Are trading personnel required to confirm in writing their acknowledgment of the various codes and to report violations? Are they required to file annual statements of indebtedness and outside affiliations? Check to see that adherence to these reporting requirements is being monitored by the compliance manager. 

7. Determine how compliance with sales-practice policies is monitored by the institution. Are personnel outside the trading area reviewing sales documents and disclosures for compliance with policies? Review and evaluate the findings of internal and external audits conducted in this area. 

8. Conduct limited transaction testing of sales documentation to review compliance with financial-institution policies and sound practices. 

9. Determine if there is a general policy concerning violations of the code. Is there a specific procedure for reporting violations to senior management and the general auditor? Does it detail grounds for disciplinary action? 

10. Recommend corrective action when policies, procedures, practices, or internal controls are found to be deficient or when violations of laws, rulings, or regulations have been noted. 

Ethics 

Internal Control Questionnaire 

1. Does the institution have a written code of conduct or ethics? Are there specific codes for capital-markets staff? 
a. Is there a statement as to the code's intention to conform with U.S. laws or laws of other countries where the institution has operations? 
b. Does this code cover the whole institution, including subsidiaries? If not, are there codes that apply to those particular areas? 
c. Does the code address specific activities which are unique to this particular institution? Do other areas of the institution with a higher potential for conflicts of interest have more explicit policies? 
d. Do the codes address the following issues: 

  Employee relationships with present or prospective customers and suppliers? Has the institution conducted appropriate inquiry for customer integrity? Does the institution's code properly address the following employee-customer or supplier relationship issues? 
- safeguarding confidential information 
- borrowings 
- favors 
- acceptance of gifts 
- outside activities 
-kickbacks, bribes, and other remunerations 
- integrity of accounting records 
- candor in dealings with auditors, examiners, and legal counsel 
- appropriate background check and assessment of the credit quality and financial sophistication of new customers 
- appropriate sales practices 

  Internal employee relationships between specific areas of the bank? 
- Do policies exist covering the relationship on sharing information between trading and other areas of the bank? 
- Is the confidentiality of account relationships addressed? 

  Personal employee activities outside the corporation? Does the institution- 
- periodically check whether employees maintain sound personal financial conduct and avoid excessive debts or risks? 
- monitor employee business interaction with other staff members, family, or organizations in which an employee has a financial interest? 
- prohibit employee use of confidential information for personal gain? provide for adequate control over trading for personal accounts? 
- require periodic disclosure and approval of outside directorships and business associations? 

  Regarding personal and corporate political activities, is the illegality of corporate political activities (for example, contributions of goods, services, or other support) addressed? 
  The necessity to avoid what might only appear to be a possible conflict of interest? 

2. Does management have the necessary mechanism in place to monitor compliance with the code of ethics? 
a. Are officers and staff members required to sign an acknowledgment form that verifies they have indeed seen and read the code of conduct and ethics? 

  Is there a periodic program to make staff aware of and acknowledge the importance of adhering to the code? 
  Are officers required to disclose their borrowing arrangements with other financial institutions to identify a potential conflict of interest? 

b. What departments and which officers are responsible for monitoring compliance with the code of conduct and ethics and related policies? What mechanisms do they employ and are they adequate? 

c. How is information in the code relayed to staff? 

  Have there been any breaches of the code? If so, what was the situation and how was it resolved? 
  Do bank personnel avail themselves of the resources outlined in the code when there is a question regarding a potential conflict of interest? If not, why? 
  Are all employees aware of the existence of the code? If not, why? 
  Does the bank's management generally believe that all potential conflicts of interest have been anticipated and are adequately covered in the code? 
  Are internal auditors involved in monitoring the code of ethics? 
  Does the organization's culture encourage officers and employees to follow the standards established by the code? 

3. Are there resources for an employee to obtain an opinion on the legitimacy of a particular circumstance outlined in the code of conduct and ethics? 

a. Does the code emphasize the need for employees to report questionable activities even when the issues are not their particular responsibility? Are the proper channels of action outlined for these types of cases? 

b. Does the code outline the penalties or repercussions such as the following for breach of the code of conduct and ethics? 

  potential to lose one's job? 
  potential for civil or legal action? 
  eventual damage to the corporation's reputation? 

4. Is the code of ethics updated frequently to encompass new activities?

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